7 Things You Should Know About Angel Investors

Ilya Strebulaev is an associate professor of finance at Stanford Graduate School of Business, and a research associate at the National Bureau of Economic Research. For more insights and ideas, sign up to receive an email newsletter at Stanford Business Re:Think.

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Many assume that the archetypal venture capital firms around Silicon Valley and Boston--the likes of Kleiner Perkins and Sequoia Capital--supply almost all the initial financing for high-growth startups.

Thanks in part to the plunging cost of technology, angels have enjoyed a growing competitive advantage in funding very early stage companies. That's because the capital required for a tech startup today is often a fraction of what it was 10 or 15 years ago. Using open-source software and cloud computing, for example, a startup that might have once required $5 million to get off the ground can often do it for just $500,000 today.

This plays to the strengths of angels, who both prefer smaller deals and are typically quicker to make decisions than venture firms backed by institutional investors. In fact, angel investors now supply the overwhelming majority of high-growth startups with their first money after the founders have tapped family and friends.

According to Jeffrey Sohl at the University of New Hampshire, angels invested $22.5 billion in more than 60,000 high-growth U.S. ventures in 2011. Traditional venture capital firms invested slightly more total money, about $28.4 billion, but they poured it into just 3,673 deals--a tiny fraction of the number of companies financed by angels.

Get to Know Angels

All this offers major new opportunities for entrepreneurs seeking seed capital. But it's easy to misunderstand how angel investors work and what they want. Having studied and watched many angels firsthand, I offer seven important insights:

1. Don't be fooled by the word 'angel .'These investors aren't donating to charity. Most are disciplined investors; they are often successful entrepreneurs and high-tech professionals in their own right. It's important to understand an angel's personal priorities. Angels may be willing to take slightly more risk with startups in a field of particular interest to them, or in companies for which they can provide specialized expertise and guidance.

2. Understand angel networks.Angel investing is a personal business, and angels rely heavily on personal networks of like-minded investors. Many angels work in groups, jointly vetting proposals and putting high value on others' opinions. Even when angel investors work separately, they share ideas and listen closely to one another. The most important key to raising money from an angel is often the good word from another angel.

3. Look close to home .Most angel investments are within 50 miles of the angel investor, and angel networks are often in geographic clusters. There's no mystery here: Early-stage investors need to stay close to the people they are betting on. Silicon Valley and Boston have particularly big clusters, but many other cities have them, as well. If you don't live near an angel cluster, consider moving.

4. Shared roots matter .Maxim Faldin and Kamil Kurmakayev, two Russian-born Stanford graduates, had no luck raising seed money from traditional VCs for Wikimart, an eBay-like site in Russia. Then they targeted their search for investors with natural affinities: those with Russian roots or international experience, and people with experience in e-commerce. That led them to Fabrice Grinda and Jose Marin--professional angels with extensive expertise in e-commerce and global markets. Today, Wikimart is thriving.

5. Angels will hunt for the fatal flaw in your plan .You may have a perfectly reasonable plan for a $10 million business. But angel investors are looking for companies that can ramp up to $50 million or $100 million in revenue. Likewise, they aren't looking for incremental improvements over the competition. They want "disruptive" ideas that will upend existing business models. If your idea is disruptive, however, can you hold on to it? Can copycats and incumbents jump in as soon as you've shown the way?

6. Your team may be more important than your concept--or even you.Angel investors want people who can execute the plan. They will place heavy weight on not only your track record, but also your management team. Beyond looking at résumés, angel investors want evidence that your team can work together when the going gets tough.

7. Angels are evolving fast .The success of traditional angels has spurred a new breed of "superangels" or "micro VCs." Like traditional angel groups, these funds invest in seed-stage companies but are structured more like traditional VC firms that raise capital from outside investors.

You also hear a lot these days about startup accelerators like Y Combinator and 500 Startups. Their approaches also seem to work well; for example, Y Combinator has graduated approximately 430 companies, including top-notch startups like Dropbox. Saeed Amidi, founder of accelerator Plug and Play, is now setting up similar structures around the world.

This may just be the start. The Jumpstart Our Business Startups Act--or JOBS Act--now allows small companies to market directly to individual investors through crowdsourcing over the Internet. This regulatory change could be the biggest shift yet for early-stage investing. One thing is for sure: Brand-name venture capital firms are not the only game in town.

This piece was originally published by Stanford Graduate School of Business and is reprinted with permission.